Pakistan's Debt Crisis: Navigating Fiscal Challenges

The fiscal landscape of Pakistan is currently facing a significant challenge, as the central government debt has surged to an alarming Rs48.4 trillion as of August 2024. This figure represents a staggering 21 percent increase compared to the same period last year. However, an intriguing twist in this narrative is the decline in the debt-to-GDP ratio, which has dropped from 74 percent to 66 percent. This paradox raises questions about the underlying economic conditions, particularly the impact of inflation on the nation’s financial health.

To understand this situation better, it is essential to recognize that while the debt is rising, the economy is also growing. Over the past two years, public debt, encompassing both domestic and external sources, has escalated by 45 percent. In contrast, the headline inflation index has surged by 49 percent, and GDP at market prices has expanded by 58 percent. This indicates that inflation is outpacing the growth of debt, suggesting that the apparent improvement in the debt-to-GDP ratio is misleading. It reflects a scenario where the purchasing power of the citizens is diminishing, even as the economy appears to be growing.

Moreover, it is crucial to highlight that the central public debt figures do not account for significant unfunded pension liabilities, which amount to Rs11 trillion for Punjab alone. When considering the total federal and provincial pension liabilities, estimates range between Rs30 trillion to Rs35 trillion, surpassing the country’s total external debt. This reality casts a shadow over the seemingly positive debt-to-GDP ratio, as it fails to encompass all the liabilities the state is grappling with. As inflation begins to stabilize, the debt-to-GDP ratio may not continue its downward trend.

In light of these challenges, the immediate focus for the government should be on reducing the fiscal deficit in the short term and addressing the primary fiscal deficit in the medium term. However, it is important to note that domestic debt servicing may not decrease as swiftly as inflation due to the time required for debt repricing. The State Bank of Pakistan (SBP) is likely to maintain high real positive interest rates, which complicates the situation further.

A critical strategy for the government should involve reprofiling domestic debt. The risks associated with rerolling and repricing have escalated, particularly as a significant portion of market debt is concentrated in Treasury Bills (T-Bills) and floating-rate Pakistan Investment Bonds (PIBs), including their Islamic counterparts. Out of the Rs37.8 trillion domestic public debt, only 19 percent is in fixed-rate instruments. The cost of floating-rate debt is considerably higher, with average yields on fixed PIBs at 13.7 percent, while T-Bill yields have skyrocketed to around 20–21 percent.

If the government had prioritized accumulating more fixed-rate PIBs, especially those with tenures of ten years or longer, the burden of debt servicing over the past two years could have been significantly reduced. For instance, fixed PIB yields have risen from 11.0 percent in June 2022 to 13.7 percent in September 2024, while T-Bill yields have surged from 8.6 percent to 20.7 percent during the same timeframe. This highlights the importance of increasing fixed-rate bonds in an economy characterized by volatile interest rates, which have fluctuated between 6 and 22 percent from 2014 to 2024.

As interest rates are now on a downward trajectory, this presents an opportune moment for the government to shift its debt profile towards long-term fixed-rate instruments. Such a move would enhance resilience against future economic crises, where inflation and interest rates may once again surge. Currently, the yields on 10-year PIBs in the secondary market are hovering around 12 percent, which is close to the yield on similar tenure papers already held by the government.

The government should continue to issue more long-term fixed-rate bonds until interest rates reach their lowest point. By increasing the share of long-term fixed bonds, the yield curve will improve, fostering a market for pension funds and supporting long-term lending for private sector projects and essential housing mortgages. This strategic shift is not just a financial maneuver; it is a necessary step towards ensuring economic stability and safeguarding the financial future of the nation.